As interest rates head higher, I’m seeing more discussion about adjustable rate mortgages, and I understand why. A lower starting payment is appealing. My goal is to help you understand how an ARM works, what it can do for you, and the potential issues to plan for before you choose that route.

How an adjustable rate mortgage works

An adjustable rate mortgage, or ARM, keeps the same interest rate for the first several years and then adjusts on a schedule. The two numbers in the name give you the timeframe. In a 5/6 ARM, the first number is how many years your rate stays fixed, which is five. The second number is how often the rate adjusts after that, which for a 5/6 is every six months for the remaining 25 years of a 30 year loan.

When the fixed period ends, your new rate is based on an index plus a margin. The index is a market-based rate that moves with the economy, and the margin is a set amount your lender adds that does not change after closing. If the index is lower at your adjustment, your rate and payment can go down. If it is higher, they can go up.

The types of ARMs

Conventional ARMs come as a 5/6, 7/6, or 10/6. The second number can be slightly confusing. On those loans, the 6 means your rate adjusts every six months. On FHA and VA ARMs, such as a 3/1 or 5/1, the 1 means your rate adjusts once a year.

What is a cap?

Caps limit how far your rate can move. Caps of 2/1/5 mean up to 2 points at the first adjustment, 1 point at each adjustment after that, and 5 points in total. Freddie Mac’s published guidelines for conventional ARMs are 2/1/5 for a 5/6 ARM and 5/1/5 for a 7/6 or 10/6 ARM, so a longer fixed period can come with a bigger first adjustment. FHA’s published limits are listed per year and in total. A 3/1 ARM can rise 1 point per year and 5 points in total, a 5/1 ARM can follow either that or 2 points per year and 6 points in total, and a 7/1 or 10/1 ARM can rise 2 points per year and 6 points in total. Always confirm the caps for the specific loan you are considering directly with the lender.

What it can look like

After the initial fixed period, rates can move in either direction. If they are lower at your adjustment, your rate could actually go down. If they are higher, your rate can go up, but only as far as your caps allow. For example, a 5/6 ARM that starts at 6.5% with 2/1/5 caps could reach 8.5% at the first adjustment and as high as 11.5% over the life of the loan. That is the ceiling and not a prediction, and this example is an illustration and not a quote.

Rates really don’t mean anything until they are translated into a real life payment, so ask your lender what your payment could look like in the worst case scenario.

Have a backup plan

A couple of years ago, plenty of buyers qualified on paper by using a temporary rate buydown, then found they could only handle the lower payment once real life expenses showed up. They counted on refinancing within a year or two, rates stayed higher than many of us expected, and those refinances did not happen. A refinance can be a great move when the numbers work, but it is never guaranteed.

I’m the type of person who likes a contingency plan. An ARM can be a helpful tool if you could comfortably afford the highest payment or you expect to move before the fixed period ends. The question to answer is what you will do if rates do not come down. You might keep the home and pay the adjusted payment, sell before the fixed period ends, or use the lower payment to build savings or pay down your balance in the meantime. Treat a refinance as a bonus and not the plan.

If you want a lender who walks you through the details and your choices, call me.